Taxes

Do Flat State-Income Taxes Produce Inequality? Would Progressive Taxes Ameliorate It?

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Over at Center on Budget and Policy Priorities (CBPP), Nicholas Johnson implies that flat taxes on income at the state level produce—or at least facilitate—increases in income inequality. On top of that, he writes, flat taxes make it harder for states to cover budget costs.

When Illinois enacted [its] single-rate rule in 1970, the income gap between the wealthy and everyone else nationwide had been falling for several decades.  Since the 1970s, however, the top 5 percent of Illinoisans' incomes have risen 123 percent — six-and-a-half times the rate for middle-income households (see chart)….

In part because of its limited revenue options, Illinois for many years did not raise enough tax dollars to cover its costs.  The state accrued nearly $10 billion in unpaid bills to doctors, child care centers, and other service providers, and it fell far behind on its pension payments. A temporary income tax increase enacted in 2011 has helped the state to slash the backlog of unpaid bills, but the state's fiscal challenges remain large.

Illinois legislators are considering shifting from a flat or single-rate income tax to a progressive one, which Johnson supports.

Not so fast, says the Tax Foundation's Lyman Stone.

If tax structure had a major impact on inequality, it should show up in state inequality data. But if we compare the average Gini coefficient (a common measure of income inequality; a higher value means more inequality) among states with different tax codes, differences in inequality are quite small, certainly smaller than differences in income and employment (see Figure 1).

As or more important, says Stone, tax-rate structure has little to do with the fiscal health of a given state. Illinois is a basket case not because they can't generate revenue via a progressive income tax but because they spend too much money on too many things.

The flat tax is not the cause of Illinois's imbalance between spending and revenue. Flat-tax states like Utah, North Carolina, and especially Indiana have all managed to pay their bills and retain AAA credit ratings, while highly progressive California had fiscal woes similar to Illinois and currently has a barely better credit rating.

Whole thing here.

The real problem with most states when it comes to spending was laid out in this 2009 Reason cover story on "Failed States":

In the five years between 2002 and 2007, combined state general-fund revenue increased twice as fast as the rate of inflation, producing an excess $600 billion. If legislatures had chosen to be responsible, they could have maintained all current state services, increased spending to compensate for inflation and population growth, and still enacted a $500 billion tax cut.

Instead, lawmakers spent the windfall. From 2002 to 2007, overall spending rose 50 percent faster than inflation. Education spending increased almost 70 percent faster than inflation, even though the relative school-age population was falling. Medicaid and salaries for state workers rose almost twice as fast as inflation.

Imagine that: If you consistently spend more than you take in, you'll go broke. Even if you bring in more money.

In a separate publication, the Tax Foundation's William McBride surveyed data on tax rates and economic growth and finds a strong consensus among academics "that taxes on corporate and personal income are particularly harmful to economic growth, with consumption and property taxes less so. This is because economic growth ultimately comes from production, innovation, and risk-taking." Read more about that here.